There are many trading strategies out there, but one of the most common is the takeover trade.
The takeover trade looks for opportunities where companies might be the target of a takeover from another company.
First, you can buy the shares in the target company immediately after the takeover announcement is made. As part of this strategy, you might short sell the acquiring company as well.
Alternatively, you might look for companies that have potential to be taken over in the future. And, if part of your investment philosophy is to look for companies you believe have growth potential, you can, in fact, be covered from two sides.
Getting the right position in a takeover trade can be very profitable.
According to a recent survey conducted by chartered accountants RSM Bird Cameron, the average premium on a takeover target in the Australian sharemarket is between 20% and 30%.
The survey found there is a marked difference between the premiums paid across the various industry sectors.
The study, which analysed 212 takeovers between 2005 and 2010, identified pharmaceutical, biotechnology and life-science companies as having the best prospects for big takeover premiums. The average premium in this sector was 37%.
The poorest performing takeover targets were in the banking and real estate sectors, with gains of about 12%.
As a side note, the report also found that details of these deals sometimes leak ahead of the market.
According to the study, target companies’ shares rise about 10% in the four weeks before the announcement – signalling that insiders are taking positions before the ‘official’ takeover announcement. No surprises there.
The low down
MM&E Capital managing director Tom Elliott, whose company has several strategies that specialise in takeover plays, said there are about 30 to 40 takeover offers made each year in the Australian market.
“Takeovers make sense because you usually have a floor in the price and that protects your downside,” Elliott said.
“Once the takeover is announced, you can either buy the shares a little below the price being offered, allowing you to pick up a couple of pennies, or buy the shares in the expectation of another bid coming along.”
Elliott said his strategy of pursuing takeover targets usually outperforms the overall market, and over the past three years of tough times in the local share market, his takeover funds have performed better than the market as a whole.
Finding a target
One of MM&E’s funds looks specifically for companies that might receive a takeover offer in the near future.
Elliott said finding companies with substantial shareholdings from companies in similar industries is one way of identifying potential takeover targets.
“We look for strategic shareholdings. In the top 300 stocks, there are probably around 50 that currently have a strategic shareholder on their books,” said Elliott.
Companies that have previously been the attempt of a takeover are also candidates for future takeovers.
“We look for previous bids. Obviously, not all bids succeed. Many times, in fact, around half the time, if a bid fails, some time in the next couple of years the bidder comes back,” Elliott continued.
Additionally, to identify potential targets, traders can look for companies that operate in industries that are experiencing many takeovers. This is called industry consolidation and will often occur over a period of years.
“At the moment you are seeing consolidation in the gold market in Australia. The majority of the medium to large gold producers have all been snapped up,” Elliott said.
Try to identify companies that have recently taken over others, or companies that have attempted to take over another company but failed.
From here, if you can work out what companies might be the next target, you might just be on the right path.
Finally Elliott suggested looking for changes in the regulatory environment.
“For example, when they changed the media ownership laws several years ago, this led to a whole bout of fresh bids within the media sector,” he added.
The first offer is rarely the last
Don’t feel like you’ve missed the boat when a stock you’ve been watching receives a takeover offer.
When a takeover offer is received, the share price of the target will usually jump to the level at which the takeover is priced.
From there, the market will be actively considering the possibility of another bid (either from the original company or a rival). More sophisticated traders can take part in an often-used hedge fund strategy. This involves buying shares in the takeover target while simultaneously short-selling shares in the bidding company.
Be comfortable with the downside
When holding a stock that has recently received a takeover offer, there is the potential for sharp falls if the takeover is cancelled or retracted.
For this reason, traders need to be aware that these kinds of trades are not risk free.
Like all markets – especially at the moment – the Australian share market is highly volatile. Therefore, if a bid is pulled, this can result in sharp losses for the unwary trader.
Don’t forget that many CFD providers allow you to use guaranteed stops. Guaranteed stops are a special kind of order that allow you to be taken out of a trade at the price you specify regardless of market conditions.
While it can sound easy to list some of the characteristics that make up takeover targets, in practice, it takes both experience and discipline to get it right.
“As you get more experience, you learn to allocate a greater amount of capital to the more prospective situations, that is, the ones in which counter bids are more likely,” Elliott said.
Also, keeping an eye on who is making the bidding can change the dynamics of a takeover.
Traditionally, private-equity bids, made by financial companies that specialise in this area, provide lower returns than those bids made by competitors, rivals of other business groups.
This is because private-equity firms are notoriously cheap bidders. On the other hand, rival groups might be willing to overpay for new sales territories, new products or to blindside a competitor.
Elliott said they are many reasons to apply a strict criteria-based from of analysis. “As we said at the outset, about 30 to 40 stocks a years are subject to a takeover offer. This equates to about 10-13% of the stocks in the top 300. If you apply the kind of criteria that do, that number can jump to 30% or 40% of your portfolio – and that can have a real impact on performance.”